Wednesday, October 21, 2009

Six Dividend Stocks for current income

Most novice dividend investors typically are under the impression that successful dividend investing entails finding and purchasing the highest yielding stocks. This strategy is flawed, because it does not take into account the sustainability of the dividend. A company, which yields 20%, might generate a much lower yield on cost over time.

I purchased American Capital (ACAS) in 2008 when this business development company was trading at $30 and was yielding 13%. Just a few months later the company suspended its dividend payment, and I sold it immediately. The thing to learn from this example is that investors have to check the sustainability of distributions in light of cash flows generated by the business, the amounts of debt relative to total assets and the amounts of interest expenses. If you find a high yielding stock, which generates enough cash flow growth and has limited amounts of debt, then it could be a buy on the next dip.

While companies are not contractually obligated to share profits with shareholders, it is nice to see when boards increase dividends and declare stock buybacks, This typically sends positive signals about management’s confidence in projected cashflows, generated by the business.In my portfolios I like to hold stocks with different yield/dividend growth characteristics. I do tend to focus mostly on the sweet spot of dividend investing, where yields are somewhere between 3% and 5% and dividend growth is in the upper single digits or in the double digits.I do realize however that some investors are interested mostly in current income generation, and not so much about future dividend growth. Thus recommending Wal-Mart with its 2% dividend yield to an investor who wants to generate as much income as possible now might sound ridiculous. Just because one wants to generate as much income as possible however, doesn’t mean that they should throw caution away with the wind. Sustainability of the dividend should be evaluated, in addition to sustainability of the dividend growth. A stock with a sustainable but unchanged dividend, which yields 9% on cost, would produce a lower inflation adjusted income level over time.

In addition to that, most studies of portfolio durability show that one should not spend more than 4% of their portfolio value each year. If you have a dividend portfolio valued at $1 million dollars, which generates $40,000/year in dividend income, and whose dividend growth closely matches the inflation rate, you are ok as long as you don’t spend more than 40,000/year. If you spend more than that, you could end up eating your principal.

Thus, even if you found the highest dividend stock, you should not be spending more than 4% of the starting value of your portfolio each year, adjusted for inflation. If you owned a 10% yielder on a $1 million portfolio, and you spend all your dividend income, you would be in trouble when one of two things happen:

1) The company cuts dividends2) The company fails to increase dividends to compensate for the eroding value of inflation

I do have several ideas on stocks with sustainable dividends that could also afford to grow them over time.

Realty Income Corporation (O) engages in the acquisition and ownership of commercial retail real estate properties in the United States. The company has increased dividends for 15 consecutive years. Check my analysis of this REIT.

Kinder Morgan Energy Partners, L.P. (KMP) owns and manages energy transportation and storage assets in North America. This dividend achiever has rewarded unitholders with regular distribution increases for 13 years in a row. Check my analysis of this MLP.

Consolidated Edison, Inc., (ED) through its subsidiaries, provides electric, gas, and steam utility services in the United States. This Dividend Aristocrat has raised dividends for 35 years in a row. Check my analysis of Con Ed.

Altria Group, Inc., (MO) through its subsidiaries, engages in the manufacture and sale of cigarettes and other tobacco products in the United States. Philip Morris International Inc (PM) on the other hand manufactures and sells cigarettes and other tobacco products in markets outside of the United States of America. Before spinning off Kraft (KFT) and Philip Morris International (PM), Altria had an uninterrupted streak of 41 consecutive annual dividend increases. The spun out companies are also likely to return increasing amounts of profits back to shareholders in the form of share buybacks and dividend increases. I like both MO and PM for global exposure to tobacco. Check my analysis of both stocks.

BP p.l.c. (BP) provides fuel for transportation, energy for heat and light, retail services, and petrochemicals products. This international dividend achiever has rewarded shareholders with dividend raises for 16 consecutive years. Check my analysis of BP.

In order to increase portfolio longevity, I would also consider at least a 25% allocation to fixed income, which would provide some buffer during bear markets and deflationary environments. In addition to that, having an allocation to lower yielding stocks with higher dividend growth characteristics could also provide a buffer for dividend increases if you are lucky enough to spend more time in retirement. After all, the worlds oldest person on record was Jeanne Calment of France (1875–1997), who died at age 122 years. For a person retiring at the age of 60 or 70, this could mean planning for a 50 to 60 year retirement. Your goal should always be for your money to outlive you, no matter what.

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